April 2013 Outlook: Sterling edges higher as debt crisis resurfaces

After an awful start to the year, sterling has benefited from a welcome boost on the exchange rates in recent weeks. A couple of positive domestic economic developments have helped matters but events in the eurozone have been the key driver, helping to put the UK’s troubles in perspective. Domestic growth data in March did little to significantly improve the outlook for the UK recovery, though a couple of bright spots have provided a much-needed source of hope. There has also been a lack of further dovish leanings within the Bank of England, though we do expect more QE to be announced in May.

There was a collective sigh of relief that Cyprus avoided an unprecedented euro-exit and more

importantly that the eurozone banking system avoided the shockwaves which would inevitably follow. Nonetheless, events in Cyprus have understandably shaken the euro in the past month. The bailout deal that Cyprus reached with the Troika will leave the country deep in recession for a long time to come but this won’t be the market’s primary concern. Alarm bells are ringing following mixed rhetoric from within the EU leadership over whether the “bail-in” – where private investors and depositors, not taxpayers footed the bill for the refinancing – represents a special case or not. Some dangerous precedents have been set and with other larger eurozone strugglers such as Portugal and Italy exhibiting some tell-tale signs of crisis further down the line, the euro could be set for a troublesome few months.

GBP/EUR

Cyprus has investors fleeing for safety

Sterling looks to have bottomed out against the euro for the time being. The wave of anti-sterling sentiment has abated for now, amid a feeling that most of the bad news is already out in the open with respect to the UK economy. If the last few weeks have taught us anything, it’s surely that all the bad news is certainly not out in the open with respect to the eurozone.                      

                            

The pound emerged from the Annual Budget more or less unscathed, despite Osborne revealing that the Office of Budget Responsibility has slashed its 2013 GDP expectations from 1.2% to just 0.6% (which will most likely be undershot). Osborne effectively passed the buck to the Bank of England in terms of efforts to stimulate UK growth, directly expanding its mandate to that effect.

The latest from the Bank of England is that Mervyn King and his two fellow doves (Fisher and Miles) remain in the minority on the key quantitative easing debate, with the other six members seemingly too concerned with rising UK price pressures. In addition, the March MPC minutes revealed that there were fears surrounding an “unwarranted deprecation in the value of the pound,” which will concern many of those betting against the pound. We feel safe predicting that there will be no dovish majority in favour of QE in this Thursday’s MPC meeting, though we see a probability that we will see the voting swing in favour in May.

UK Q1 GDP figure comes into focus

Growth in the UK clearly remains very weak indeed. February’s data revealed the worst monthly construction growth in three years, whilst manufacturing is also firmly in contraction territory. Gladly, there was some relief in that the dominant UK services sector posted its best figure in five months and February’s 2.1% retail sales growth was excellent.  However, the key issue of whether or not the UK economy will avoid a triple-dip recession, when its Q1 GDP figure is announced on April 25, remains finely balanced. The March PMI figures released over the coming sessions will be highly significant; this morning’s manufacturing update got things off to a weak start but as ever, the pressure will be on Thursday’s services figure to deliver again.

Dangerous precedents will hurt the euro

While, there have been some rare sources of positivity with respect to domestic developments, this pair’s recent climb is explained mostly by events in the eurozone. Cyprus stole the headlines; the dreaded euro-exit has been avoided once again but the market has been left with some rather uncomfortable lessons. In a fundamental shift in eurozone banking relations, private individuals and companies with large amounts of cash in European banks now find themselves at risk of other potential ‘bail-ins’ in other struggling nations. This new credit risk is likely to leave a major psychological mark on euro-depositors and will have many heading to the exits and targeting perceived safer options like the GBP and USD.

Where will the next debt crisis hotspot be? Italy is looking a decent bet. Political instability is not the only issue the country faces, economic contraction remains a major issue and perhaps more pressingly, the health of Italian banks is deteriorating at an alarming rate. If things continue at this rate then Italy could find itself in a similar position to Cyprus, in need of recapitalising its banks, with Germany opposing a fix-all bailout from the European Stability Mechanism.

Some dangerous precedents have been set in Cyprus in terms of depositors being forced into a ‘bail-in,’ senior bondholder suffering haircuts, major and extended capital controls being implemented, the ECB imposing strict deadlines on their liquidity provision. Lines in the sand have been drawn, which are fundamentally likely to undermine confidence in the euro.

Debt crisis to one side, eurozone data has remained disappointingly true to its downtrend.  Monthly growth data from Spain, France, Germany and the eurozone as a whole has all undershot expectations, which suggests that Draghi is being more than a little overoptimistic with respect to his expectations that the region’s recession will stabilise soon. Naturally, events in Cyprus have hurt confidence and sentiment gauges.

Sterling has recently posted seven-week highs of €1.1890, although this pair currently trades over a cent off this level. We do see GBP/EUR recovering further in the weeks ahead, particularly if the BoE delays QE this month and the UK services figure is solid. Asian reserve managers already appear to be responding to eurozone developments by taking a step back from the euro. We see this trend continuing, which could take this rate as high as €1.20 in the weeks ahead.

GBP/USD

Sterling finally enjoys a bounce

There is no doubt that sterling’s safe-haven status has waned in recent months, in line with the loss of the UK’s AA credit rating. It has therefore been no surprise to see the USD benefit from the lion’s share of safe-haven currency flows stemming from increased tensions in the eurozone. Nonetheless, the pound has managed to eke out some gains in the past three weeks or so, despite the uptrend in US economic figures.

Those economic figures have revealed a particularly strong increase in US retail sales and industrial production. However, with housing market data mixed and consumer sentiment gauges indicating some weakness, there remains more than enough cause for concern to see the Fed continuing with QE3 for the time being. Indeed, the Fed recently downgraded its 2013 GDP projections in anticipation of a fiscal drag later this year.

More improvements in US labour market

As ever analysis from inside the Fed and therefore throughout the market, will focus on the US labour market, from which the news has been distinctly positive over the past few weeks. The US unemployment rate dipped back down to 7.7% in February- its lowest level since February 2009, while the headline figure revealed 236,000 jobs were added to the payrolls – the biggest monthly increase in a year. There is plenty here to fuel the Fed hawks’ calls for scaling back QE3 but the bottom line is that Bernanke and his fellow doves still require further progress. They may well get what they want as this Friday’s key US labour market update once again promises to be robust.

There were some notable phrases within the Fed’s March statement, among which was the emphasis that the central bank has the ability to vary the pace of QE3 in response to changes in the US economic outlook. So it really does seem as if they are gearing us up for fazing QE3 out, though this remains conditional to labour market progress.

Sterling may well face some short-term weakness if the UK services figure disappoints and there is room here for a move down to $1.5050. However, our baseline scenario is for a further upward correction for this pair. A move up towards $1.55 is possible in the weeks ahead, though this comes with the caveat that the UK must avoid a triple-tip recession (no sure thing). Beyond this near-term upward correction, we maintain a negative outlook for this pair in H2 2013, in line with our positive outlook for the US dollar.

GBP/EUR: €1.20

GBP/USD: $1.53

EUR/USD: $1.27

Richard Driver
Analyst – Caxton FX

For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

Germany succumbing to peripheral eurozone weakness

Today’s session has seen some nasty eurozone growth data emerge, which has put the euro under even more selling pressure. Yesterday’s was a tough enough session for the single currency thanks to Moody’s credit downgrade to five Spanish regions; sterling/euro has helped itself to some very welcome gains again today.

Attention as far as the euro has been concerned has been focused on Spain’s “imminent” bailout request and Greece’s slow progress towards an agreement on further austerity measures that will unlock the next tranche of aid. Focus switched back to economic fundamentals today, which is not an environment in which the euro has thrived in recent months thanks to the regional downturn in economic growth. Brutal austerity measures throughout the eurozone periphery are not just hurting those struggling economies, the weakening demand is hitting the eurozone’s core, as shown by today’s German and French growth data.

September’s German manufacturing data suggested the weakness we have seen in the sector this year had bottomed out but October’s downturn casts a shadow over this theory. France’s manufacturing number came in below expectations, as did that of the German services sector.

A key gauge of the German business climate showed a sixth consecutive monthly decline, giving its worst showing since March 2010. What is interesting is that Ifo, the institute which produces the business climate survey, does not see any need for the European Central Bank to cut interest rates and does not see Germany heading into recession.

We are rather more bearish on the prospects of the European powerhouse. The composite measure of eurozone output has fallen to a 40-month low and points to an even sharper contraction in Q4 compared with Q3. Germany’s resilience to the eurozone region’s decline is a thing of the past and we are expecting a rate cut from the ECB in the coming months. The ECB might be doing its bit to ease concerns over eurozone contagion and a break-up, but growth in the region is crying out for help. 

Richard Driver

Currency Analyst

Caxton FX

Caxton FX Weekly Round-Up: GBP, EUR, USD

Standard and Poor's cuts Spanish credit rating but Rajoy still delaying 

Rating agency Standard and Poor’s cut Spain’s credit rating by another two notches last week, which puts the country’s debt only one notch above ‘junk’ status. Moody’s already has Spain at this level but when it publishes its report in a fortnight, the market response could be very negative indeed if it does in fact downgrade Spain to junk territory. Speculation that Standard and Poor's axe wielding would prompt an aid request from Spain intensified last week but the latest reports suggest that not only will Rajoy wait until after regional elections on October 21 but he will wait until November before officially requesting a bailout. More delay then, though at least we have an idea of timescales.

Interestingly though, Spain’s bailout looks set to become part of a larger package containing a bailout for Cyprus and an amended loan package for Greece. This will relieve EU officials of the requirement to repeatedly obtain approval from the eurozone’s national parliaments. In terms of the eurozone’s other key problem child, a Greek deal on a new austerity package is likely to be agreed in time for this week’s EU Summit, which should help to set market nerves at rest with respect to the next tranche of Greek aid.

In terms of eurozone data this week ,we have a key German economic sentiment gauge released on Tuesday, which looks likely to improve slightly, though probably not enough to trigger any rally for the euro.

Big week of UK announcements ahead 

Last week brought a lull in terms of UK news. We learnt UK manufacturing production underperformed in August and that the UK trade deficit widened quite dramatically, but the week ahead brings plenty of key domestic figures. UK inflation is set to take another sharp downturn, which could well embolden the more dovish members of the MPC to vote for more QE next month. The minutes from the last MPC meeting are also released on Wednesday, which may be slightly more downbeat based on September’s weak PMI growth figures. This could potentially hurt the pound if it is enough to convince investors that a few members will be swayed to vote for more QE in November.

UK labour data looks set to be solid again on Wednesday, while we should also see some better growth from the UK retail sector. The market will watch all these figures closely but one eye will be kept on next week’s (October 25) initial Q3 UK GDP estimate. This is the next major event for sterling this month.

We are expecting plenty of range-bound trading this week, with EU leaders set to put off major announcements until next month. Having failed once again ahead of $1.61, GBP/USD looks set to return to the $1.60 level. We are sticking to our guns in terms of our predictions that when this pair does finally make a sustained break away from the $1.60 level, it will be to the downside. The euro continues to look tired as it approaches the $1.30 level and a dip below $1.29 looks possible this week.

Sterling is struggling to sustain any significant gains against the euro. We expect the €1.2350 will provide plenty of support in the sessions to come, so we’d view current levels to strong ones at which to sell the euro. A break higher back up towards €1.26 isn’t out of the question this month.

End of week forecast
GBP / EUR 1.2450
GBP / USD 1.5975
EUR / USD 1.2850
GBP / AUD 1.5800

Richard Driver
Currency Analyst
Caxton FX

German confidence tumbles again, pointing to possible German recession

A monthly German survey, which covers around seven thousand firms, has been released this morning to reveal that German business confidence has declined for the fifth consecutive month. A flat reading was expected but German business confidence has now dipped to its weakest level seen since March 2010. The news provides further evidence of the dampening effects of the eurozone debt crisis on the region’s powerhouse economy and has accordingly weighed on the single currency today.

Firms in manufacturing, construction, trade and industry were mostly responsible for the poor climate reading, though retail and wholesale trade did improve slightly. The regional downturn is having a particularly noticeable impact on Germany’s exports to other eurozone nations. The economic weakness being seen in major nations like Spain, Italy and even France cannot be viewed in isolation; recessions are particularly contagious in a currency union like the eurozone and this morning’s data indicates that Germany is succumbing.

Interestingly though, an economist from the producers of the data - the Institute for Economic Research - has stated that German consumption remains robust despite a weaker labour market and therefore does not see a need for an interest rate cut from the European Central Bank. An interest rate cut would however weaken the euro, which could boost exports outside the eurozone, though this would require Germany’s preoccupation with high inflation to be set aside. The IFO economist did also note that the survey was taken prior to the positive decision from the German Constitutional Court earlier this month, the uncertainty surrounding which may be at least partly responsible for the unexpected decline.

The economic downturn is not just bad news for Germany but for the eurozone’s peripheral nations as well. If Germany enters recession, then it is going to be increasingly difficult for Merkel to justify and deliver the support she is pledging for struggling nations like Spain and Italy. With plenty more austerity measures still to come across the eurozone, the prospects for the economy as a whole and Germany by association, are rather gloomy. After Q2’s 0.3% GDP growth, Germany may avoid economic contraction in Q3 but the same is unlikely to be true in Q4, such is the downtrend that is in place. This is not to say that Germany is certain to enter a recession but the risks are very significant and it is looking increasingly likely, which is bad news for all concerned.

We may have seen some progress on the debt crisis in the last month or so but economically, the region is in very poor shape indeed, which is in part why we maintain a negative outlook for the euro.

Richard Driver

Currency Analyst

Caxton FX

Spanish bailout will come but not for another month

The newswires have today been full of speculation over the imminence of a Spanish bailout. The FT has reported this week that negotiations between Spain and the EU are going places. The two parties are working on an economic reform programme which is rumoured to be unveiled next week. Note though, this is only a prelude to a bailout request.  

What is Spanish PM Rajoy waiting for? Well, regional elections in the Basque country and Galicia are being held on October 21 and Rajoy is likely to wait until after that, as a bailout request before this date would more likely than not damage his Conservative party’s chances. This end of October period coincides with some major Spanish debt repayments and is probably as long as the market is willing to wait for some concrete progress.

There is something to be said for getting in early with a bailout request whilst bond yields are away from their record highs, so that Rajoy is in a better position to negotiate favourable bailout conditions. If Rajoy waits until the situation returns to panic mode, Spain’s creditors could have him over barrel.

Next Friday’s release of the Spanish banking sector’s stress tests could well spook the markets and send bond yields soaring up to 7.0% again but on balance we expect Rajoy to wait until late October, just in time for the ECB’s meeting in the first week of November. This leaves time for bailout conditionality to be ironed out between the interested parties.

We believe Rajoy will use the next month to try everything he can to achieve the best result for his country. He is under huge domestic political pressure by an increasingly angry and volatile population and cannot afford to be seen to sacrifice more than is absolutely necessary in return for a bailout. Everything should be in place by the end of October and until then, the euro is likely to come under increasing selling pressure.

Richard Driver

Currency Analyst

Caxton FX

Swiss National Bank holds firm on EUR/CHF floor

Away from the wild speculation surrounding the US Federal Reserve’s meeting this evening and away from the strides being made in the eurozone, the Swiss National Bank gave its quarterly monetary policy assessment this morning. As expected, the SNB kept interest rates on hold in the 0-0.25% band. Slightly more interesting than this, however, was the SNB’s decision to reiterate its commitment to defending the EUR/CHF floor (or ceiling if you prefer to look at it that way) of 1.20.

Since the escalation of the eurozone debt crisis, the safe-haven franc attracted huge investment and the excessive appreciation that this caused was damaging to the Switzerland’s economy. In August 2011, the Swiss National Bank responded by intervening in the currency markets to weaken the franc (put simply, buying lots of euros and selling lots of francs). In September 2011, the SNB set a floor for the EUR/CHF exchange rate, pledging to use all the resources at its disposal not to allow the franc to strengthen past this point (below a rate of 1.20).

Since September 2011 then, any dip below the 1.20 threshold has been fleeting and marginal, but the market has certainly tested the SNB’s resolve. Central banks currency intervention is historically very unsuccessful and expensive, just ask the Bank of Japan. Up until now though, the SNB is doing a remarkably good job but only time will tell. 

Swiss National Bank's statement this morning has told us that they expect the Swiss economy to grow by 1.0% this year, down from the 1.5% growth they expected three months ago (though this is still a decent pace of growth). In addition, the SNB also sees consumer prices falling by 0.6%, more than initially expected, with inflation expectations for 2013 and 2104 also downgraded. 

In light of downgraded growth and inflation expectations, the SNB was quite clear on its on-going commitment to maintain the EUR/CHF floor this morning, stating that “If necessary, it stands ready to take any further measures at any time.” It’s not surprising either, the swiss franc remains overvalued. With near-term risks to Swiss growth high given the poor growth outlook for the eurozone economy, the SNB is likely to maintain its defensive stance in the medium term. However, talk of shifting the floor even higher up to 1.25 looks unlikely to be realised, as the SNB will probably view this as too risky. 

Richard Driver

Currency Analyst

Caxton FX